Insurance & ILS are shock absorbers for climate, but need adjusting to the risk: McKinsey

Insurance products, reinsurance and insurance-linked securities (ILS) are all examples of financial shock absorbers for climate change risks, but while it can encourage behavioural change through the sending of price signals, a new report from McKinsey highlights the reality that the sector business models may need to change.

Leaders in business, politics and society are encouraged by McKinsey to factor climate risk assessment and adaptation into their decision making, as a new climate normal emerges for corporates, investors and governments.

With the physical risks of climate change present and growing, a report from McKinsey warns of the potential for significant knock-on effects, as huge amounts of activity, economic or otherwise, could be put at risk if adaptation and mitigation isn’t embraced.

The report warns that climate change could reshape the very financial markets the world and humanity relies upon, with nonlinear effects possible as certain system thresholds are breached and financial markets are as at-risk of this as people and society.

Financial markets may result in the recognition of climate risks being brought forward dramatically, which may have significant consequences for capital allocation and insurance in particular, McKinsey warns.

“Greater understanding of climate risk could change risk recognition including making long-duration borrowing unavailable, reduce insurance cost and availability, and reduce terminal values,” the company’s research suggests.

Capital allocation changes, as investors become increasingly aware of the climate risks in different asset classes, is already happening, and asset repricing is surely not far behind as the evidence behind climate change related risks increases.

These two factors can drive significant changes through insurance and risk markets, which may have ramifications for the broader reinsurance and ILS sector as well.

Using Florida as an example, the report highlights estimates that suggest losses from flooding may devalue exposed properties by $30 billion to $80 billion, or 15% to 35%, by as soon as 2050.

Clearly the ramifications from such an event would be significant, in particular for homeowners and businesses whose insurance costs would likely be rising at the same time as the asset they are insuring is losing value.

That has ramifications for demand, affordability and use of insurance, with knock-in effects for the reinsurance and ILS market as a result.

“Much as thinking about information systems and cyber-risks has become integrated into corporate and public-sector decision making, climate change and its resulting risks will also need to feature as a major factor in decisions,” Jonathan Woetzel, McKinsey Global Institute Director and Senior Partner of McKinsey Shanghai said.

“We were surprised by the magnitude and timing of these physical risks, and their potential impact on human lives, natural systems, the economy and the financial system,” added Dickon Pinner, Senior Partner in San Francisco and Leader of McKinsey’s Sustainability practice globally.

McKinsey’s report goes into some more detail on the ramifications for the insurance and reinsurance sector, saying that the industry will need to be adaptive itself, in tandem with societies efforts to adapt to climate change risks.

As climate risks become better measured the only response is higher costs from insurers, or changes to deductibles, limits available and terms.

But in a world where climate risk is rising, financial protection becomes even more important, even if the costs of it are rising too.

Making it essential for the insurance industry and its capital backers in reinsurance and insurance-linked securities (ILS) to identify how it needs to adapt to ensure it’s providing a product that is still useful, while being as affordable as possible.

Again using Florida as an example, insurance costs may rise from the increasing awareness and understanding of climate change related risks, while at the same time losses could rise for the sector as exposure increases and storms have a greater impact.

Which together could drive much faster rate increases than the industry and its customers have been used to so far, driving the need for reinsurance capital to also be accurately priced, as well as fairly at the same time to help sustain the marketplace.

There’s a mismatch here as well, that could exacerbate issues for the property insurance market in particular.

McKinsey explains, “Insurance systems are designed so that property insurance is re-priced annually; however, home owners often have longer- term time horizons of 30 years or more on their real estate investments. As a result of this duration mismatch, home owners could be exposed to the risk of higher costs, in the form of rising premiums (which could be appropriate to reflect rising risks), or impacts on the availability of insurance. Similarly, debt levels in many places are also at thresholds, so knock-on effects on relatively illiquid financial instruments like municipal bonds should also be considered.”

Of course, insurance, reinsurance and ILS instruments such as catastrophe bonds have a significant role to play.

McKinsey’s research highlights the increasing physical risks, saying, “As the climate continues to change for the next decade and probably beyond, the number and size of regions affected by substantial physical impacts will continue to grow. This will have direct effects on socioeconomic systems in five areas: livability and workability, food systems, physical assets, infrastructure services, and natural capital.”

The financial impacts could be significant indeed, meaning climate risk hedging and risk transfer capacity and structures (traditional and alternative) are going to become increasingly intertwined with financing to mitigate the climate exposure of investments and assets.

But, while insurance and financing tools have been designed to mitigate risk, there is a chance that “intensifying climate hazards could stretch their limits,” McKinsey believes.

The availability and price of insurance and reinsurance capacity could be impacted, as it naturally should if the risk itself or losses from it is increasing.

But the concern here is the potential for this to happen at an unprecedented rate and how the re/insurance industry might itself adapt and cope with this.

“Insurance can help provide system resilience to recover more quickly from disasters and reduce knock-on effects. It can also encourage behavioral changes among stakeholders by sending appropriate risk signals—for example, to homeowners buying real estate, lenders providing loans, and real estate investors financing real estate build-out,” McKinsey says.

The company highlights parametric risk transfer, catastrophe bonds and the capital markets as a source of large-scale insurance and reinsurance capacity, all as positive elements that can assist in helping the world manage climate exposures.

But the market itself faces risks.

McKinsey says, “As the climate changes, insurance might need to be further adapted to continue providing resilience and, in some cases, avoid potentially adding vulnerability to the system.

“For example, current levels of insurance premiums and levels of capitalization among insurers may well prove insufficient over time for the rising levels of risk; and the entire risk transfer process (from insured to insurer to reinsurer to governments as insurers of last resort) and each constituents’ ability to fulfil their role may need examination.”

This is going to require a response from the industry and there is a need for adaptation within insurance, reinsurance and the ILS market itself, to ensure there is continuous availability of coverage and at the most affordable risk-commensurate prices possible.

“Without changes in risk reduction, risk transfer, and premium financing or subsidies, some risk classes in certain areas may become harder to insure, widening the insurance gap that already exists in some parts of the world without government intervention,” McKinsey warns.

Innovative responses are required, such as wrapping catastrophe bonds into municipal bond type structures, leveraging the capital markets for climate and disaster insurance, as well as designing more responsive risk transfer arrangements as well. Join us at our upcoming New York conference for more on some of these topics.

McKinsey’s report is lengthy and goes into much greater details on the potential impacts to society and industry from climate risks.

The small amount of the report focused on insurance makes it very clear that the industry has a lot of work to do and needs to ensure that it is not only protecting itself, through its understanding and pricing of climate risks, but also protecting people, businesses and society through appropriate risk transfer products as well.

Also read:

– Institutional investors backing ILS call for climate action.

– Climate threat needs capital response, but industry has to give it confidence.

– Climate change adaptation financing can benefit from partnership with ILS.

– Climate change “front & center” with ILS investors, industry focus intensifies.

– Loss creep, AOB & climate change seen as biggest challenges: Survey.